The First Deal: The Division of Founder Equity in New Ventures

Abstract

This paper examines the division of founder shares in entrepreneurial ventures, focusing on the decision of whether or not to divide the shares equally among all founders. To motivate the empirical analysis we develop a simple theory of costly bargaining, where founders trade off the simplicity of accepting an equal split with the costs of negotiating a differentiated allocation of founder equity. We test the predictions of the theory on a proprietary dataset comprised of 1,476 founders in 511 entrepreneurial ventures. The empirical analysis consists of three main steps. First we consider determinants of equal splitting. We identify three founder characteristics—idea generation, prior entrepreneurial experience, and founder capital contributions—regarding which greater team heterogeneity reduces the likelihood of equal splitting. Second, we show that these same founder characteristics also significantly affect the share premium in teams that split the equity unequally. Third, we show that equal splitting is associated with lower pre-money valuations in first financing rounds. Further econometric tests suggest that, as predicted by the theory, this effect is driven by unobservable heterogeneity, and it is more pronounced in teams that make quick decisions about founder share allocations. In addition we perform some counterfactual calculations that estimate the amount of money "left on the table" by stronger founders who agree to an equal split. We estimate that the value at stake is approximately 10% of the firm equity, 25% of the average founder stake, or $450K in net present value.

More from these Authors

Akhil Patel is passionate about his business idea: an innovative green technology fuel cell. He wants to dive in and commit to his startup, but Roopa Rao, his fiancee, is much more risk averse, his parents don't approve of the startup, and Akhil has an enticing alternative offer from a prestigious consulting firm. Should Akhil follow his dream and become an entrepreneur? Or should he acquiesce to the other forces in his life and take the "safer" consulting job?

Earl Martin Phalen is in the midst of starting his second non-profit organization, Summer Advantage, by implementing the lessons he learned from BELL, the non-profit he had founded and run for the prior 15 years. His aspirations for Summer Advantage were to make it "bigger, better, and faster [than BELL]. I am going to serve more children, more effectively, and for less money." In the midst of taking a very different approach to financing, staffing, and running Summer Advantage, he received an offer to become non-founding CEO of a much bigger non-profit, and is grappling with whether to take the job offer.